The FDR Framework is the backbone for a 21st century financial system. Under this framework, governments ensure that every market participant has access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to analyze this data because they are responsible for all gains and losses.

Friday, December 7, 2012

German regulator briefed about valuation of derivatives by Deutsche

The Financial Times reports that BaFin, the German bank regulator, was briefed about the valuation of Deutsche's derivatives book that three whistle blowers claim was mis-priced by $12 billion.

Regular readers know from the JP Morgan London Whale trade that it is not the responsibility of the bank regulators to "value" the derivatives book for other market participants or to specify what value for the derivatives must be disclosed.

Bank regulators do not approve or disapprove of any exposure taken by the banks as this would put them in the business of allocating capital.

Rather, bank regulators focus their attention on answering the question of does the bank have enough capital to absorb the losses that are expected to occur from its various exposures.

It is very important to understand that bank regulators are not now nor have they ever been in the business of "valuing" a bank's exposures. They might question the valuation assigned by the bank, but they are not a pricing service that provides a bank with a valuation that can be used in the bank's financial statements.

Hence, even if the regulators were briefed about the valuation of Deutsche's derivative book, it doesn't mean the bank regulators blessed hiding a $12 billion shortfall.

This is one of the reasons that your humble blogger has called for requiring the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this information, market participants would exert discipline on the banks to properly value their exposures.

German regulators were briefed about Deutsche Bank’s valuation of a clutch of complex derivatives now under investigation by the Securities and Exchange Commission. The revelation potentially sets up a transatlantic regulatory conflict with US investigators.

There is no conflict because the German bank regulators were not there to enforce disclosure to market participants.

It is the SEC's job to ensure that market participants have access to all the useful, relevant information in an appropriate, timely manner so that investors can independently assess this information and make a fully informed investment decision.

For banks, this requires the banks to provide ultra transparency.

People familiar with the valuation process said BaFin, the German banks supervisor that is Deutsche’s principal regulator, routinely sat in on audit committee meetings during the 2008-09 period, when the bank failed to recognise up to $12bn of paper losses, according to allegations made to the SEC by three former bank employees.

The regulators might have attended the meeting, but it was not their role to do more than question how much the bank might lose on its derivative book exposures.

The Financial Times reported on Thursday that, according to three separate complainants, Deutsche failed to mark down the falling value of so-called leveraged supersenior trades. If the assets – worth a notional $130bn – had been properly accounted for, Deutsche could have required a government bailout, the allegations say.

Senior management and some members of the supervisory board were also aware of the valuations, which one person involved said were lowered by a “few hundred million euros” after KPMG, the bank’s auditors, were consulted. The extent of their scrutiny is unclear.

It is in fact KPMG's responsibility to be sure that Deutsche Bank's financial statements accurately reflect the financial condition of the bank. They sign the auditor's letter affirming this fact.

As a result, KPMG had to be comfortable with how the derivatives book was valued.

News that BaFin was aware of the valuations could lead to tensions with the US regulator, which has been looking at the allegations for more than two years.

Experts also said the German regulator’s stance might complicate the SEC’s efforts to bring a case, because the bank would be able to argue it did not intend to break any rules....

Again, the regulator was not there to "rule" on the accounting treatment of the derivatives book. It was there to assess how much could be lost.

The revelations have alarmed some of Deutsche’s supervisory board members, who are planning to study the affair at meetings of the audit and risk committees next week. “This could become a huge issue and there will be a lot of questions asked,” one board member said.

This is a big issue as market participants have no reason to trust Deutsche's financial disclosure documents. Who knows how much in the way of losses is currently being hidden given that Deutsche's management didn't think that disclosing a $12 billion loss was necessary.

The only way that market participants are going to trust Deutsche again is if it provides ultra transparency.

The supervisory board members would be well advised if they voluntarily adopted ultra transparency next week.

About this blog

A blog on all things about Wall Street, global finance and any attempt to regulate it. In short, the future of banking and the global financial system.

This blog will be used to discuss and debate issues not just for specialists, but for anyone who cares about creating good policies in these areas.

At the heart of this blog is the FDR Framework which uses 21st century information technology to combine a philosophy of disclosure with the practice of caveat emptor (buyer beware).

Under the FDR Framework, governments are responsible for ensuring that all market participants have access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to use this data because under caveat emptor they are responsible for all gains and losses on their investments; in short, Trust but Verify.

This blog uses the FDR Framework to explain the cause of the financial crisis and to evaluate financial reforms like the ABS Data Warehouse.